1. Field of the Invention
This invention relates generally to markets for the exchange of derivative securities, such as option contracts.
2. Background Discussion
Conventional trading of securities, such as, for example, stocks, exchange traded funds (“ETFs”), and listed equity options, takes place on a national securities exchange that is registered as such with the United States Securities and Exchange Commission. The options market first developed in the 1970s. Options for the purchase and sale of listed stocks once were traded domestically only on floor-based exchanges, for example, the American Stock Exchange (AMEX). The method of trading options contracts in these floor-based environments is known as an “open outcry” system because trading takes place through oral communications between market professionals at a central location in open view of other market professionals. In this system, an order is typically relayed out to a trader standing in a “pit.” The trader shouts out that he has received an order and waits until another trader or traders shouts back a two-sided market (the prices at which they are willing to buy and sell a particular option contract), then a trade results. In an effort to preserve this antiquated system of floor-based trading, the transition to and use of computer-based technology on these exchanges has been slow. Some of the processes that take place on these floor-based exchanges have been automated or partially automated.
Exchanges now may be floor-based, fully-electronic, or utilize a hybrid model that incorporates some floor-based features and some electronic features. An example of a floor-based exchange is the New York Stock Exchange (“NYSE”). An example of a fully-electronic exchange is the International Securities Exchange (“ISE”). An example of a hybrid exchange is the Chicago Board Options Exchange (“CBOE”).
By way of background, markets rely on the skills of market professionals known as market makers, who are responsible for maintaining liquidity in the market. Market makers fulfill this responsibility by ensuring that there is always a two-sided market through providing prices (quotations) at which they are both willing to buy (bid) and sell (offer) a particular option contract and honoring those quotations when trading with incoming orders.
In an electronic market, market makers provide constant quotes—a price to buy and a price to sell a particular financial instrument. As used herein, financial instrument includes a derivative instrument, such as an options contract to purchase or sell a quantity of an underlying instrument, for example, shares of stock. As used herein, a product refers to a range of derivative instruments (e.g., option contracts) that relate to the same underlying instrument, for example, all options on an IBM stock. Some market makers for an options market provide quotes in all instruments (i.e., all options traded on the market). As the market moves, the market makers update their quotes accordingly. The quotes are live and can be traded against by any other party. Options are particularly challenging for market makers because a very large number of instruments may be traded on a single exchange. For instance, the International Stock Exchange (ISE) trades 250,000 different instruments. Many market makers submit firm quotes for all 250,000 instruments. To maintain accurate prices for all their quotes, market makers submit about 20,000 new prices to the market each second. As a result, market makers are an example of a high frequency traders. High frequency traders submit quotes on large numbers of instruments, typically on the order of hundreds of thousands and do so in a relatively short period of time. The rate at which high frequency traders submit quotes to a market is typically limited only by the speed that computers and communications systems can handle such quotes. This rate may be in the tens of thousands per second.
Occasionally there are technology issues that prevent a market maker from updating quotes, causing prices to be stale or incorrect. When this happens, the market price may move so that the market maker's quotes are disadvantageous. To limit their exposure, market makers react by deleting all of their quotes until the technical difficulty is resolved. Once the problem is corrected, they reload the quotes. Deleting quotes takes time and often the market makers experience losses because trades are executed against mis-priced quotes before the market maker can delete them. This in turn makes the market makers less willing to provide their best quotes.
Another problem arises when market makers resubmit a large number of their quotes after deleting them. If the market maker's computer system can send 20,000 quotes per second, and there are 250,000 quotes in the market, it takes over ten seconds to reload all the quotes. Moreover, reloading so many quotes at the same time causes all network systems to give poor response times. This additional load may lead to the same kinds of technical problems that caused the market maker to delete its quotes in the first place. The market maker removed its quotes because it thought there was a problem, and now it is putting new quotes back into the market and they are being reloaded in a sluggish manner. The market maker may not be able to tell if the initial problem is resolved.
The tools that the market maker has to address these issues are a) a “mass delete” function, which lets the market maker remove all its quotes, and b) a “selective delete,” such as the “Speedbump” function provided by the ISE, which removes the market maker's quotes for all instruments in one product if the number of contracts traded in a set period of time exceeds a pre-determined threshold. In either case, until the problem is resolved the market marker ceases to send new quotes to the market, at least for product that caused the mass delete or triggered the speed bump. Because quotes are not flowing to the market, it is difficult for the market maker to determine what went wrong. Another problem resulting from market markers deleting and reloading quotes is a disruption in the price discovery function that sets the Best Bid and Offer (the “BBO”) for the exchange. The BBO is calculated as the total size available on exchange at the best bid price and best offer price. The BBO is updated with each order and quote entered onto the market. When a market maker deletes all of their quotes it creates a massive spike in the market data volumes. This spike interrupts the market data stream reporting the BBO.